Zuk’s Nukes – A Bearish Take on VET-LXE; Don’t Believe the Strip

Zuk’s Nukes – A Bearish Take on VET-LXE

VET/LXE; not covered; no rating

I can resist everything except temptation. -Oscar Wilde

Abundance is a curious thing. Too little of it, and you’ll wonder if the good times will ever come back; too much of it, and one is prone to spend like the good times will never end. $100/bbl oil, I fear, may be bringing an exuberance to M&A, which we haven’t seen for some time.

VET is paying an astonishing 4x PDP NPV10 or 4.5x AFF 2022e for LXE ($477mm), on a company, dare I say (given I-banker back channels), was soft-pitched for several years and struggled to get a bid. One hedge fund I know well ended up punting a large block to another group by dint of pure frustration on the lack of activity, and that sentiment likely wasn't a lonely one. LXE generated just $1.9mm in 3Q21 AFF (1,817 boepd); even annualized, with a 10x order of magnitude thrown on, this strikes me as a massive win for LXE shareholders, and a questionable one for VET.

Recent Deals

What I like about the deal:

• All Cash Bid?– As they should, all CEOs are programmed to think their paper is undervalued, so it behooves them to dole out as little as possible. VET is doing that here, using FCF and bank line capacity. A minor win for equity holders.

What I don’t like about the deal (and I’m a VET shareholder):

• Everybody Gets Rich in Excel?– Spend enough time doing shifty cannabis/psilocybin deals, and you learn excel will spit out any future CF number you want it to. We all get rich…next year. LXE is a far cry from ACB or WEED, but the hockey stick in ‘t + 1’ makes me think I am back in 2017. Some quick napkin math below, and again, recall LXE 3Q21 was just 1,817 boepd and the press release is advertising 13,000 boepd in 2022e:

• Asset Diversification? I specifically tucked VET in the portfolio (at $20/sh) because I wanted exposure to the gong-show European PC/ESG/Russia policy has wrought on the supply/demand balance. $30/mmbtu – yes, please. $150/bbl Brent – it’s coming. VET has diluted what I wanted leverage to, in favour of assets that I could get high-graded exposure to in a BIR, or ARX, or TOU.
• Funny Money on Deal Metrics –?LXE has yet to report 4Q21, and current production is unknown, but even against the contrived 2022e ramp-up, I note that 4.5x AFF represents almost double what we were seeing in the basin; further, against trailing numbers, $8mm AFF yields an incredulous 55x AFF purchase price. Arguably, CNQ-SRX provides a more relevant water mark at 4.0x, but all other reserve metrics showcase this deal being done at twice the cost (eg 4.0x PDP NPV10 vs 2.2x CNQ-SRX). LXE’s future inventory?may?be rich enough to pay such a premium, but perhaps that says more about the buyer’s existing runway, than it does the seller’s…

Don’t Believe the Strip

A steeply backwardated curve illustrates the exigency of market participants to pull crude from storage/reserves to market –?stat! Then, as near-term supply/demand dynamics are ‘solved,’ it is believed we can (or ought to) return to a normalized price environment (which is what? $75-85/bbl?).?

The data shows the CME WTI strip, much like EIA forecasts, are quite inaccurate. The March ‘21 strip had May ’22 WTI trading at $55/bbl. Ok, that was a different climate. Even in Jan ’22 the current month contract was for $84/bbl – note, this was before Russia invaded Ukraine on Feb 24, ’22.

There is another way to look at this problem. Distant month futures prices have traded at wild discounts to the actual price we see in today’s dollars. It is precisely these discounts which I am calling into question. As mentioned above, in January ’22, with relative near-term clarity to price dynamics, the May contract was $30/bbl lower than the actual price we see today.?

To sum, we have two compounding effects happening: 1) prompt month aggressively moving up on geopolitical risk, and 2) the tail of the strip not reflecting the tightness we will see – and have seen, evidenced above – which means locking in / hedging prices 6-12 months out could very well be taking +$20/bbl off of netbacks.?

Speculators (i.e. money managers) may have driven WTI to $130/bbl, clipped a nice profit, then exited, but open interest on all benchmarks has dropped vertiginously, and yet WTI is back to $105/bbl. This suggests the physical market?is?actually this tight and may even be getting worse as the supply call goes unanswered.

Last week, total products drew down 11.6 MM bpd (including a 4.1 MM draw from the SPR).

Most importantly, the EIA reports?do not?include the recently announced import bans on Russia; those start in May ’22.

As always, open to questions/comments.

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Michael A. Zuk

Managing Partner

Athena Capital Markets

www.athenacapitalmarkets.com

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